How does a debt relief program affect your credit?

44388380_MWhen you’re deep in debt, you’re unlikely to be thinking about your credit score. Trying to provide for your family while working to make repayments is the priority.

Although debt relief programs are there to help you get out of debt, you need to fully understand how each option will affect your credit rating in the long run. This post examines the things you need to know.

Understanding Credit Score

A credit score is a number that combines multiple factors to evaluate your creditworthiness. The credit model most commonly in use was created by the Fair Isaac Corporation (FICO) and it uses a scale of 300 to 850. Here’s a rough guide on what the numbers mean.

  • 800 to 850 (Excellent)
  • 740 to 799 (Very good)
  • 670 to 739 (Good)
  • 580 to 669 (Fair)
  • 300 to 579 (Poor)

Lenders and financial institutions use your FICO score to decide if you’re worthy of a loan, how much they’re willing to offer, and at what interest rate. Factors like the amount of your current debt, frequency of loan application, and debt management as indicated on your payment history affect your credit score.

That’s why it’s crucial to maintain low debt while ensuring you regularly make monthly repayments to improve your credit score.

Debt Relief Programs and Credit Score

There are a variety of debt relief programs including debt management, debt consolidation, debt settlement, and bankruptcy. However, they all impact your credit score in different ways. Let’s now look at the relationship between each type of debt relief option and your credit rating.

Debt Management

This option allows you to enlist the help of a credit counselor to work with your creditors to come up with a responsible repayment plan that you can manage. The debt management plan outlines how much you have to pay every month and the total duration. Your counselor holds you accountable for sticking to the plan. During the repayment period, you may be disallowed from applying for additional credit.

Impact on Credit Score

If you’re looking for a way to relieve your debt without ruining your credit scores, this option is recommended. Provided you keep up to your new repayment plan, your credit rating would not be affected.

Debt Consolidation

This is the act of securing a new loan to pay off other liabilities and unsecured consumer debts. Multiple debts are consolidated into a single, larger debt with better payoff terms. This way, you get to streamline repayment and save money on interest. However, there’s a minimum level of creditworthiness you need to have to qualify for a consolidation, which depends on the lender.

There are two prevalent methods of debt consolidation. You can use a new personal loan or debt consolidation loan to combine your debts into one. On the other hand, you can concentrate all your existing credit card debt into one by using a balance transfer credit.

Impact on Credit

If managed responsibly, debt consolidation should not affect your score. However, if managed with indiscipline, you can find yourself in a worse situation than you started.

Consolidating your debt with a credit card or new loan is usually accompanied by a hard inquiry that may impact your score. Luckily, it is usually small and short-lived. If you’re 30 days (or more) late on your payments, it can hurt your credit rating as payment history is one of the biggest factors that affect credit scores. Applying for loans that you do not qualify for may also hurt your credit rating.

Debt Settlement

Debt settlement is a process when you engage a third-party company to help you negotiate with your creditor to reduce your debt or get a better payment plan. One common approach is to negotiate for a lump-sum that is less than what you currently owe. In return for their service, the debt settlement company charges a percentage of the amount of debt saved.

Impact on credit score

During the negotiation process, debt settlement companies typically ask customers to stop making payments to the lender. Since payment history is the most significant factor that affects credit score, you should expect a plunge in credit rating. Higher credit scores typically fall farther than lower credit scores.

Fortunately, the drop after a debt settlement is quite manageable and short-lived. Many people tend to complete the repayment process in about 2 to 4 years and may successfully wipe off thousands of dollars in outstanding secured debt. Since the fall isn’t as bad when compared to declaring bankruptcy, it’s easier to rebuild your financial life and credit score.

Declaring Bankruptcy

This is usually the last resort when it’s obvious that no matter what you do – reducing expenditure or negotiating for a better repayment plan or debt settlement – you cannot pay off your debt. Declaring bankruptcy is a complex legal process that involves a federal court and for optimal results, getting a bankruptcy attorney can be helpful.

There are two common chapters you can file – Chapter 7 or Chapter 13. Chapter 7 bankruptcy involves the liquidation of your assets that are not exempt which is then used to pay off your creditors. On the other hand, in Chapter 13 bankruptcy, none of your assets are sold. However, you agree to a court-approved repayment plan. Typically, the due debt must be paid within 3 to 5 years.

Impact on Credit Score

Declaring bankruptcy has the biggest impact on your credit score because you’ve consistently defaulted in your monthly payments, indicating your lack of creditworthiness.

However, Chapter 13 is more favorably viewed than Chapter 7 because it shows a willingness to repay your debt.

Even more disheartening is that bankruptcy is public information, meaning anyone can get their hands on it. Chapter 7 bankruptcy will stay on your credit report for 10 years, while chapter 13 bankruptcy will stay there for 7 years. During this process, it may be difficult to secure new loans, mortgages, and even get some jobs.

Conclusion

When opting for a debt relief program, there’s a likelihood that it negatively impacts your credit. However, this doesn’t mean you should consider them.

Based on your specific situation, temporarily lowering your credit score may be the most efficient way to escape the ocean of debt. And once you get your financial life back on track, you can consistently work your way towards improving your credit.

Don’t deal with debt alone – reach out to us today for help.

Related Posts